1

Recitation 8
Suggested Answers

Keywords for Review: Marginal revenue, monopoly, uniform pricing, price-discrimination, mul-
tiplant production, welfare loss, Pareto efficiency and improvement.

Problem 1 – Monopoly and Profit Maximization: Consider the demand for schnitzel in New
York City illustrated in the diagram below. Suppose there is a single seller of schnitzel who acts
as a single-price monopolist.

a) Indicate the profit-maximizing price and quantity.

Optimality states that the optimal quantity follows from M R = M C and the optimal price
from the demand with Q∗ . Hence, the profit-maximizing price is P1 and quantity Q1 .

b) List the areas of consumer and producer surplus.

The consumer surplus is A and B. The producer surplus is C, D, F, G, and I.

c) Suppose the seller begins perfectly price-discriminating. How many schnitzels will she sell?

The seller will sell Q2 schnitzels.

d) What happens to areas A and B when the seller begins perfectly price-discriminating?

Once the seller begins to perfectly price-discriminate, areas A and B, the original consumer
surplus, become part of the new producer surplus.

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e) What happens to areas E and H when the seller begins perfectly price-discriminating?

Areas E and H are no longer the deadweight loss but become part of the producer surplus.

Problem 2 – Multiplant Monopolist: Rizer has developed and patented Migra, a new medicine
that cures migraines. Patents grant their holders the right to exclude others from producing the
patented product. It has been estimated that the market demand for Migra is given by QD =
200 − 2P per day, where Q is measured in thousands of pills and P is the price for 1,000 pills.

a) What is the equation of the MR? Why is the MR always smaller than the price? Explain the
intuition for your answer.

1
QD = 200 − 2P ⇒ 2P = 200 − Q ⇒ P = 100 − Q
2
 
1
M R = 100 − 2 ∗ Q ⇒ M R = 100 − Q
2

The marginal revenue is smaller than the price because the demand is downward sloping.
dP
MR = P + Q
|{z} dQ
gain in revenue | {z }
f rom additional unit loss in revenue because
of lower price

dP
Because < 0, then M R < P .
dQ
In words: The marginal revenue is the additional revenue from selling an additional output
unit. This additional revenue is smaller than the price at which this additional unit is sold
(what happened in perfect competition) because selling an additional unit entails a lower price
on all units sold (not just the additional one). This second (negative) component involves the
marginal revenue being smaller than the price.

The marginal cost of producing Migra is M C = 4 + Q.

b) Given the cost and demand functions, how many thousands of pills will Rizer sell? Assuming
that producing Migra does not involve fixed costs, what will be Rizer ’s profits? Illustrate
your answers on a graph.

Profit-maximizing output:
96
M R = M C ⇒ 100 − Q = 4 + Q ⇒ Q = = 48 (thousand)
2

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Rizer will sell 48 thousand pills.

Profits are represented by the blue trapezoid in the graph (Profits = Producer surplus because
there are no fixed costs).
1
P = 100 − (48) = 100 − 24 = 76
2
M R = 100 − 48 = 52
48 ∗ [ (76 − 52) + (76 − 4) ]
PS = = 2, 304
2

To reduce costs, Rizer is considering outsourcing parts of its production process. For simplicity,
assume that Rizer can use an alternative plant with a constant marginal cost of 30.

c) How many thousands of pills will Rizer produce in each plant? What is the effect of intro-
ducing the new plant on the welfare of consumers? Illustrate the change in the welfare of
consumers graphically (not numerically) and indicate the new profits on the graph.

M C1 = M C2 ⇒ 4 + Q1 = 30 ⇒ Q1 = 26(thousand) (1)

The profit maximizing condition requires that M R = M Cnew and M R = M Cold . Let’s use
the first condition because MCnew is not a function of quantity, so the computation is easier.
Recall that the MR depends on the total quantity placed on the market. Thus,

M R = 100 − Qtotal = 100 − Q1 − Q2 (2)

M R = M C1 ⇒ 100 − Q1 − Q2 = 30 ⇒ Q1 + Q2 = 70 (3)
Q1 = 26 ⇒ 26 + Q2 = 70 ⇒ Q2 = 70 − 26 = 44 (4)

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Because the quantity produced increases, the price drops. Therefore, consumers are better off.
The area in green shows the change in consumer surplus, and the new profits are indicated in
blue.

d) Does outsourcing lead to a Pareto improvement? Does it lead to a Pareto efficient allocation?
Explain.

Because both consumers and producers are better off, outsourcing leads to a Pareto improve-
ment. However, the surplus is still not maximized, which is not a Pareto-efficient allocation.

To contain the price of drugs, the Food and Drug Administration (FDA) supports the introduction
of generic drugs. When patents and other exclusivity periods expire, other manufacturers can
apply to the FDA for the sale of “generic” versions of the brand drugs (generic drugs have the same
active ingredient as the brand drug). It has been shown, however, that while generic drugs sell
at a much lower price, the price of branded drugs does not decrease much. On the contrary, the
price of brand drugs sometimes increases after introducing their generic version. Assume that the
market for generics is perfectly competitive and that, even though the generic has the same active
ingredient, some consumers are convinced that Migra is better than its generic. Also, assume that
Rizer can use both plants.

e) Discuss why it may be profitable for a brand name leader like Rizer to introduce when the
patent expires, an “in-house” generic version of the brand drug (in other words, Rizer would
produce both Migra and its generic version) even though the generic sells at a lower price.
What is the minimum price of the generic version of Migra that will induce Rizer to enter
the generic market?

It would be profitable for Rizer to introduce an “in-house” generic version of the brand drug
if it can successfully price discriminate between the two markets. By doing so, Rizer can
increase its overall profits.

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Under a monopoly, Rizer excluded from the market consumers willing to pay less than the
monopoly price. By introducing a generic version at a lower price, Rizer can sell at a higher
quantity overall because the lower price incentivizes additional consumers to purchase the
drug. Therefore, if Rizer can successfully convince a segment of consumers (through adver-
tising) that Migra differs from the generic version, it can split consumers into two groups.
Rizer can then price discriminate between these two groups, charging a higher price in one
market to consumers willing to pay more for Migra while charging a lower price in the second
market for consumers willing to purchase the cheaper generic brand.

Rizer would enter the generic market as long as it is profitable—in other words, as long as
the MR in the generic market is higher than the MR for Migra in monopoly. This latter
MR equals 52 (as obtained in the previous question). Therefore, the minimum price for the
generic Migra that would induce Rizer to sell the generic version of Migra is 52 (recall that
in perfect competition, the MR is equal to the price).

Note that when the generic version is introduced, the demand for Migra may shift inward.
However, if the shift is limited, the answer (P = 30) does not change (remember that M C is
equal to 30 for any quantity greater than 26).

Problem 3 – Monopoly and Price Discrimination: A video game producer has fixed costs
of $25,000 per month and marginal cost of $5. The firm has a capacity constraint of 15,000 units.
The market research group has indicated that the demand for video games can be represented by
P = 9.8 − .0002Q.

a) One firm manager feels that the price should be set at the level that maximizes the firm’s
revenue. At what price is this objective accomplished? What are the firm’s profits at this
price?

Revenue is maximized when MR = 0.

9.8
M R : 9.8 − .0004Q = 0 ⇒ 9.8 = . 0004Q ⇒ = Q ⇒ Q = 24, 500 units
.0004
Note, however, that with the 15,000 capacity constraint, the firm would not be able to pro-
duce the revenue maximizing amount of output. Therefore, the level chosen is full capacity:
Q = 15, 000 units ⇒ P = 9.8 − .0002 ∗ 15, 000 = 6.8 ⇒

Profits: (P − AV C) Q − F C = (6.8 − 5) ∗ 15, 000 − 25, 000 = $ 2, 000

b) Other managers think that they should maximize profits. What price should the firm set to
maximize profit? What quantity of output would the firm sell? What are the firm’s profits?

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Profits are maximized at the Q where MR = MC,

M R = 9.8 − .0004Q

MC = 5
4.8
M R = M C ⇒ 9.8 − .0004Q = 5 ⇒ Q = ⇒ Q = 12, 000
.0004
P = 9.8 − .0002 ∗ 12, 000 = 7.4
The firm would sell 12,000 units at the price of $7.4

P rof its : 7.4 ∗ 12, 000 − 5 ∗ 12, 000 − 25, 000 = $ 3, 800

In other words, the company reduces its production, but profits increase.

The firm can sell in a second market that is separated from the first market. For the second
market, the market research group has estimated the demand for that specific videogame to be
P2 = 6.8 − .0001Q2 .

c) Some firm managers believe that this second market offers an opportunity for additional
profit. Are they right? In other words, should the firm sell any units in this market? With-
out capacity constraints, how many units would the firm sell in each market? Given that
the firm cannot produce more than 15,000 units, how many units would the firm sell in each
market? What is the price in each market? (Hint: Allocate one half of the fixed costs to each
market.)

Market 1: M R1 = 9.8 − .0004Q1

Market 2: M R2 = 6.8 − .0002Q2
Both markets: M C = 5 f or 1 ≤ Q ≤ 15, 000
Profit maximizing allocation of sales: M R1 = M R2 = M C

9.8 − .0004Q1 = 5 and 6.8 − .0002Q2 = 5

Q1 = 12, 000
Q2 = 9, 000
These would be the quantities without capacity constraints.

Because we cannot produce more than 15,000, we cannot fully maximize profits in both mar-
kets. Therefore, we cannot use the M R1 = M R2 = M C condition. However, this
does not prevent us from achieving a profit-maximizing allocation of sales with Q1 + Q2 =
15, 000, M R1 = M R2 ⇒ Q2 = 15, 000 − Q1

9.8 − .0004Q1 = 6.8 − .0002 (15, 000 − Q1 ) ⇒ 9.8 − .0004Q1 = 6.8 − 3 + . 0002Q1

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⇒ 9.8 − 3.8 = . 0006Q1 ⇒ = Q1 ⇒ Q1 = 10, 000
.0006
Q2 = 15, 000 − Q1 = 15, 000 − 10, 000 = 5, 000
P 1 = 9.8 − .0002 ∗ 10, 000 = 9.8 − 2 = $ 7.8
P 2 = 6.8 − .0001 ∗ 5, 000 = 6.8 − .5 = $ 6.3

d) Suppose that the capacity constraint is loosened and the firm could produce one additional
unit beyond 15,000. In which of the two markets will this additional unit be sold? Is your
answer consistent with the fact that the two markets have different prices? Explain.

On the margin, the two marginal revenues are the same:

M R1 = 9.8 − .0004 ∗ 10, 000 = 9.8 − 4 = 5.8 (5)

M R2 = 6.8 − .0002 ∗ 5, 000 = 6.8 − 1 = 5.8 (6)

The firm would be indifferent about where to sell it (the price does not matter; what matters
is the marginal revenue).

Even better: Selling the additional unit in one of the two markets only will result in a disparity
of the MRs in the two markets (before this sale, they were equal to each other). The best
strategy would be to allocate portions of the additional units in the two markets until the new
MRs are the same.

U6300: Microeconomics for International and Public Affairs Fall 2023